There is a serious downside risk to Canada’s grocery sector if the superior margins it enjoys compared to the U.S. decline over the next two years, says a new industry report.

The big three grocers have long had substantially higher margins than their U.S. counterparts. But if they were to erode under unrelenting competitive pressure, Loblaw Cos. Ltd. shares could decline by 24% to $32, Metro Inc. shares by 30% to $44, and Sobeys’ owner Empire Co. shares by 39% to $44, according to an analysis published Wednesday by BMO retailing analyst Peter Sklar.

Major Canadian incumbent grocery players . . . will have a tough hill to climb in the foreseeable future

“With already intense competitive activity expected to continue, an absence of food inflation, a strong U.S. dollar (which increases procurement costs), and a cautious consumer, we believe the major Canadian incumbent grocery players — namely, the three publicly traded grocers Loblaw, Sobeys and Metro — will have a tough hill to climb in the foreseeable future,” he said in the report.

The rapid expansion into Canada’s food-selling business by U.S. giants Walmart, Target and Costco accounted for roughly two-thirds of the industry’s 3% growth in square footage over the past year.

“The 3% industry square footage growth in 2013 was well in excess of Canada’s demographic growth rate of about 1%,” Mr. Sklar noted.

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The stepped-up competition in the Canadian grocery sector has already affected retailers.

Both Sobeys and Metro have experienced decelerating operating profit growth over the past few quarters and the trend continued into negative territory over the last two reported quarters, Mr. Sklar noted.

Grocers have watched the trend with rising alarm. Metro chief executive Eric La Flèche last fall warned the pace of growth was not sustainable.

“If your square footage in the market is growing at 3% to 4%, and the total market is growing less than 1%, that is not good news, so I think at some point there has to be more of a balance,” he said. “The population is not growing that fast, so it has and will have to balance out.”

But balance does not appear to be in the tea leaves.

Walmart Canada last week said that it will spend about $500-million this year on 35 building projects, including six new stores between now and next January to bring its Canadian store count to 395. All of the building projects will add more food space inside the retailer’s cavernous stores, and it will sell groceries at 282 of its stores by next year.

“Every store where I can put food, I will put food,” Shelley Broader, company chief executive, told the Financial Post in an interview last week.

Costco, meanwhile, plans to build up to 25 more warehouse stores in this country.

Mr. Sklar’s current calendar forecasts for 2014 and 2015, in line with those of other industry analysts, assume the companies will be able to hold up their margins.

Quarterly earnings margins before interest, taxes, depreciation, amortization and rent costs at Loblaw, Sobeys and Metro have ranged from 6.5% to as high as 9% over the past two years. But U.S. grocers Kroger and Safeway have averaged about 5%.

But looking at the potential downside given the ongoing environment, “we believe it is possible that the Canadian grocers could experience an EBITDAR margin decline of 100 basis points below current forecasts over the next two years,” Mr. Sklar said.

If such margin compression were to occur, the analyst believes the companies could also experience a downward revaluation of at least half a multiple point on the earnings margin measure.

He said Empire has the most to lose given the mitigating factors of Loblaw’s acquisition of Shoppers Drug Mart and Metro’s ongoing share buybacks.

The impact on Loblaw and Metro are further mitigated by substantial interests in Choice Properties REIT and Alimentation Couche-Tard, respectively, the analyst added.